New Homebuyer Tax Credit Proposal: Impact on the Housing Market

On Nov 6, President Obama signed a measure to extend the $8,000 first-time homebuyer tax credit, along with a $6,500 tax credit for repeat homebuyers who have lived in their current homes for at least five years. To qualify for the credits, applicants must sign a purchase agreement by April 30, 2010, and close by June 30, 2010, and have annual incomes below $125,000 (for individuals) and $250,000 (for joint filers). Income limits were previously $75,000 for individuals and $150,000 for joint filers. In addition, the home being purchased must be for the applicant’s primary residence (i.e., no vacation homes or investment properties) and priced at no more than $800,000.

Until now, we’ve been predicting that home values will likely bottom in the second quarter of 2010. But the tax credit could change that substantially, for several reasons.

• Because of the extension to existing homeowners and the doubling of the salary limits for applicants, the new tax credits represent a substantial increase in the pool of eligible buyers, thus translating into more demand for housing.

• This increased demand due to the tax credits will soak up some of the foreclosures expected to flood the market in 2010. We still expect foreclosures to increase over the coming months before peaking next year, bringing more cheap inventory into the market.

• The spur in demand comes during the real estate market’s slow winter season, so it may help even out seasonal declines in home sales, which were expected to translate into downward price pressure. Spring and summer 2009 proved good for home values, as they flattened substantially. But fall and winter, even in the best of times, normally bring sagging demand and, this year, it looked like Q4 was shaping up to be a really dismal period in the real estate market. Part of this was due to demand that was pulled forward into Q3 by buyers trying to take advantage of the tax credit that was originally set to expire Nov. 30. The expectation was that this weakened demand would translate into renewed declines in home values. The presence of the tax credits, however, which would expire at the end of June (for contracts completed by April) could bring increased demand to the market during this normally slow season.

The tax credits, however, could be costly. We looked at the possible impact of extending only the $8,000 first-time homebuyer tax credit for an additional 12 months, and determined the total cost of that would be $14.86 billion. We also determined that it would spur an incremental 334,000 sales (sales that would not have occurred without the credit; based on a survey, we found that four of five sales of homes to first-time homebuyers would occur regardless of the tax credit.) The government is estimating that an extension will cost the government $10.8 billion in lost tax revenue.

Moreover, a large amount of this new demand attributable to the new tax credits will likely be borrowed from the future, which suggests we could pay for it later. And ultimately, these foreclosures will have to move through the system. That said, these policies can change the near-term trajectory of home prices, from one featuring further declines in home values, followed by a more robust recovery in prices to a trajectory featuring a stabilization of home values now, followed by a longer period of flat performance. Either way, we’re quite likely to end up at the same price level in several years time, regardless of the path we take to get there.

Finally, don’t forget that the extension of the tax credit to existing homeowners brings not just demand into the market, but also an equal amount of supply (i.e., they have to sell their home in order to buy another.) The existing tax credit to first-time home buyers was pure demand. Every buyer that was spurred to enter the market helped push inventory levels down by increasing demand relative to supply. With the existing homeowner tax credit, current homeowners are trading homes between themselves. What will be interesting to see is whether this game of musical chairs unfolds in an orderly fashion (i.e., some homeowners buying a new home before selling theirs; others doing the opposite) or whether skittishness about the market will lead more homeowners to try to sell their home first before buying a new one. The latter scenario could lead to more near-term supply than demand, which will push inventory up and prices down.

Regardless of where one nets out on the particular merits of the tax credit, what’s becoming even clearer is the tremendous importance of stemming the tide of foreclosures. Compare the estimated 300K+ incremental home sales the $8,000 tax credit could bring about next year with the almost three million homes that are estimated to be somewhere in the foreclosure pipeline. It’s like draining your bathtub with a spoon while leaving the faucet running. Loan modifications are clearly not making a dent in the problem and we’ll never be able to buy enough demand to compensate for all the foreclosures.

This leaves policies targeted at income support and job creation; which can help keep people in their homes in the first place. Compared to the $10B price tag for the housing tax credits, the $2.4B Congress spent yesterday to extend unemployment benefits looks like a bargain and ideas are starting to circulate now about how to get more credit flowing to small businesses so they can start hiring now that the economy is officially growing again.

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